Tax-Free Income Making More Sense in Global Financial Crisis

Will tax rates be going up? What happens to retirement income when taxes increase?

Currently, income tax and capital gains tax rates are at historically low levels.

The US government debt is now $31+ trillion, with $170+ trillion unfunded liabilities. State and individual debt loads are similarly bad.

How are various government entities going to finance skyrocketing debts and deficits?

Well, of course, the US government could simply “print money” to finance its spending, as usual. (The 50 states are not allowed to print money, so their financing options are limited.)

Assuming, however, that the federal government does not abandon its fiscal habits, we can further assume that federal and state income tax rates will rise sharply in the future. [See Deficit Myth by Stephanie Kolten for a different, more sensible monetary approach.]

So, a strategy to reduce future taxation of retirement income probably makes financial sense.

Too many people have too much of their retirement savings in taxable investment accounts and pre-tax tax-deferred retirement plans (e.g., IRA, 401(k), 403(b) plans). Even though many people will be earning less income in retirement, it is likely that higher overall income-tax rates will erode retirement income. Furthermore, investment accounts and tax-deferred retirement plans that are heavily invested in the stock market are subject to the downside risks and market volatility, as 2022 markets have shown us.


Solutions to get tax-free income: (1) Shift some assets from taxable investment accounts, CDs, money market accounts into indexed universal life insurance (IUL). (2) While tax rates are still low, pay taxes on current income and invest the post-tax amounts in Roth accounts or (even better) in IUL. (3) If you are 10 years or more away from retirement, start “rolling over” pre-tax retirement plans (e.g., IRA money) into post-tax Roth plans. (4) Transition assets into one or more asset-based tax-advantaged long-term care (LTC) policies, which provide tax-free LTC benefits. (5) Invest pre-tax earnings in a 401(h) medical savings account (the tax trifecta: contributions, growth and distributions are tax-free).

Caveat: If your employer offers matching contributions in a pre-tax 401(k), 403(b) or other tax-qualified retirement savings plan, then without a doubt contribute to the deferred-tax plan up to the maximum matching amount.

In a Roth conversion, funds from an IRA, 401(k) or other tax-deferred plan are “rolled over” into a Roth plan and taxes are paid on the converted amount. If conversion of a large account value is contemplated, since the converted amount is immediately taxed as income, it can be done over a number of years to avoid being catapulted into high tax brackets.

Simply reducing taxable income in retirement can bring benefits. Reducing taxable income lowers so-called “provisional income”, which determines taxation of social security income. Taxable income also influences “modified adjusted gross income” (MAGI), which determines the level of Medicare premiums. Thus, reducing taxable income not only saves taxes on that income, but also reduces taxation of Social Security benefits and reduces Medicare premiums.

Generally, as with pre-tax plans, a 10% penalty is paid on Roth-plan withdrawals before age 59½. Roth IRAs have no required minimum distributions (RMDs), but Roth 401(k) plans do have RMDs starting at age 72 (currently), just like standard pre-tax plans. Furthermore, when the owner of a Roth IRA or Roth 401(k) plan dies, the beneficiary is subject to RMDs.

So, is there a better way than a Roth account to include tax-free income in retirement and legacy planning? Yes. A properly-designed IUL policy (indexed universal life insurance) can provide benefits of tax-free growth and tax-free income similar to a Roth plan, while providing other important advantages that Roth plans lack.

For example, cash value in a IUL policy never goes down in a bear market. Although conventional retirement plans often allow investing in risk-free annuity policies, assets in both pre-tax standard plans and post-tax Roth plans are typically invested in equity stocks and are, therefore, subject to market risks, such as volatility and extreme downturns (e.g., the financial crises of 2000 and 2008, and 2022′s inflation and recession), or in conservative, low-return bonds. In contrast, IUL has a 0% floor, meaning its account values do not go backwards as a result of negative market returns. Yet, IUL grows in a positive market because its account values are linked to the percentage growth (but never the negative returns) of one or more market indices. Another major benefit of IUL is the leverage of the insurance death benefit, which is effective immediately upon policy purchase. For example, if the insured happens to die in year 1 of the policy year, the policy beneficiary receives a large insurance death benefit. In contrast, if you start saving in a standard pre-tax plan or in a post-tax Roth plan, and if you suddenly die in year 1, then your beneficiary receives your initial year-1 investment and its year-1 growth, that is, not much. Additionally, IUL typically includes so-called accelerated benefits (or living benefits), based on the death benefit, for an insured who is chronically, seriously or terminally ill. Also, IUL does not have RMDs. Finally, IUL (and life insurance generally) can be owned by an irrevocable trust for estate and legacy planning.

With a time horizon of 10-15 years or more, building wealth using IUL is almost always a good choice.

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